IRS plans increased NRA examination activity.

As a direct result of the knowledge the Service gathered from the Voluntary Compliance Program (VCP), it is redirecting its resources and significantly increasing the number of audits of Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. According to an IRS representative, all Forms 1042 throughout the country will be reviewed as part of a package audit for each and every income tax audit. In addition, the Service will initiate approximately 200 Form 1042 audits that are not part of a package audit. To meet the increased enforcement demands, it has trained more than 400 agents throughout the U.S. and added additional international agents to the team in New York, dedicated to providing technical guidance to managers of large-case audits.

There are approximately 40,000 taxpayers that currently file Form 1042; of these, nearly 30,000 are small payers (i.e., those with deposit requirements of less than $10,000), leaving about 10,000 taxpayers with significant payments to nonresident aliens (NRAs). Over the next three-year cycle, 50 agents will be conducting exclusively Form 1042 audits, examining roughly one-third of the population of taxpayers that make significant payments to NRAs. Barry Shott, IRS Director, LMSB Financial Services Industry, indicated that this population would include taxpayers engaged in financial services, as well as pharmaceutical companies, law firms, publishing companies, high-tech companies and other entities that typically make payments to NRAs. Over the next six years, the majority of withholding agents can expect to be reviewed. Audits of Form 1042 are already under way; thus far, the Service has identified at least two occurrences of intentional disregard with respect to Form 1042 filings. Letters initiating additional Form 1042 audits were mailed to taxpayers at the end of June 2006, with more to follow. The trend is expected to increase.

VCP

The VCP, described in Rev. Proc. 2004-59 and extended by Rev. Proc. 2005-71, allowed taxpayers to report noncompliance with tax withholding and reporting obligations under Sees. 1441, 1442, 1443 and 1461. The Service required each participating taxpayer to submit comprehensive information on all procedures, procedural failures and the number of persons affected by its failures to comply with the reporting and withholding rules. In addition, each taxpayer was required to submit a calculation of the total taxes it failed to withhold and a description of any corrective measures it intended to implement. In return, the IRS allowed the taxpayer to cure noncompliant items, pay taxes owed and avoid certain penalties and interest otherwise due. Taxpayer interest in the VCP was high; the Service extended the original submission deadline from Dec. 31,2005 to March 31, 2006. Approximately 400 taxpayers participated in this program.

Examination Will Differ Significantly

The roles of the IRS and taxpayer under audit will differ significantly from their roles under the VCP. Under audit, the Service will determine (1) payments made by the taxpayer to foreign persons, (2) which of these constitute "fixed or determinable annual or periodic" income and (3) which of these are U.S.-source payments. The determination of the U.S.-source income used by taxpayers for other purposes will be compared to the U.S.-source income reported to NRAs. With this information, the IRS will determine a taxpayer's reporting and withholding obligations. In addition, upcoming regulations should prevent interest from being imposed if there is no underlying tax liability. The early 18-month period for curing items and obtaining retroactive forms under the VCP will not be available under audit. Additionally, the Service will be looking at Forms 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, and 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, filed by the taxpayer.

According to an IRS representative, issues raised on examination may include concerns about NRA documentation, such as faxed forms, foreign language forms without accompanying English translation, joint accounts with missing documentation, retroactive statements with missing signatures, and forms with a U.S. address but no additional explanation or documentation. In addition, the Service may examine a taxpayer's application of the presumption rules, as well as the use of appropriate employer identification numbers (EINs) and Social Security numbers on Form 1042-S and NRA documentation (e.g., a withholding foreign partnership EIN is formatted as "98-033XXXX"). IRS representatives have indicated that any taxpayer that did not participate in the VCP should be prepared for a thorough Form 1042 audit and that it does not expect to issue "no change audit" reports going forward.

Conclusion

Taxpayers that did not participate in the VCP should prepare for upcoming audits by identifying and evaluating all U.S.-source payments made to NRAs, reviewing existing documentation and curing any questionable or out-of-date forms. Ignorance of reporting and withholding responsibilities will not constitute a defense on audit. Once an examination begins, a taxpayer will have limited time to make any necessary changes. In addition, it should disclose any issues or systemic problems surrounding its withholding and reporting, to minimize exposure to penalties under Sec. 6662.

FROM MELODY TWIGG, J.D., WASHINGTON, DC, AND IRIS GOLDMAN, CPA, AND MARVIN MICHELMAN, CPA, NEW YORK, NY